Investors Seeking Yield Often Take on Greater Risks

Several New Reports from Baird Wealth Management Outline Investment Alternatives in a Low Interest Rate Environment

MILWAUKEE, June 23, 2011

Today’s low interest rate environment continues to create challenges for yield-seeking investors. As available yields across different asset classes remain compressed, investors are increasingly looking to less traditional investments, and in the process, may be unknowingly taking on more risk. New reports published by Baird’s Private Wealth Management Research team outline some of the choices investors may want to consider in their quest for yield – Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs) and unconstrained bond funds – and the risk/return considerations that should accompany those investment decisions.

Low Interest Rate Environment Not Likely to Change SoonAccording to Baird’s Chief Investment Strategist Bruce A. Bittles, rates are unlikely to rise soon. “Long-term bond yields are most sensitive to inflation expectations and the level of fed funds,” Bittles wrote in a recent Market Note. “We think inflation will slow for essential products and the Fed will likely remain on hold into next year’s election. Bond yields are anticipated to remain low and stable over the next several quarters.”

In this environment where the 10-year Treasury note recently fell below 3%, Baird Senior Fixed Income Research Analyst Craig Elder likes callable agency bonds with “step up” coupon rates – a pre-set coupon rate “step up” that provides for increases in interest rates or the coupon rate as the bonds approach maturity, which minimizes the interest rate risk for investors over time. He also favors agency bonds issued by government-sponsored enterprises (GSEs) such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae) and the Federal Home Loan Banks that provide credit for the housing sector.

For those in tax brackets above 35%, Elder favors municipal bonds. “Munis are attractive to many investors because the interest income is exempt from federal income tax and, in many cases, state and local taxes as well,” he said. “For investors in the top tax bracket, the after tax yields are still higher than any of the other major investment-grade fixed income sector classes.”

While some investors have gravitated toward high yield bonds, Elder is concerned about valuation in high yield as he believes credit spreads are too low. He recently published a report,“Need Yield? Look at these Fixed Income Sectors,” outlining his recommendations.

Yield Alternatives and the Risk/Return Involved“The Quest for Yield: The Roles of Dividend and Interest Income,” a new whitepaper from Baird, explores the importance of dividend and interest as components of total return and the alternatives available to investors seeking higher yields. According to Laura Thurow, CFA, Co-Director of Baird Private Wealth Management Research, “There are a number of alternatives out there that investors may not be aware of because they haven’t had to be. Many of the alternatives bring greater risk and volatility. We advise investors exploring these alternatives to be aware of what they are buying and to maintain adequate diversification.”

It’s important for investors to give careful consideration to how much risk they want to assume. “Though investors may be hesitant to accept lower returns, we caution them not to chase higher yield opportunities without full consideration of the risk/return trade-offs, as they may inadvertently be taking on more risk than they realize,” Thurow said. Bonds and dividend paying common stocks are among the most common ways investors add yield to their portfolio. Less traditional vehicles explored in this whitepaper as well as in other Baird research reports include Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs) and unconstrained bond funds.

Real Estate Investment Trusts (REITs)For many, Real Estate Investment Trusts (REITs) have been an attractive investment vehicle to generate additional income. According to Elder, carefully selected REIT Preferred Stock is a good value now. REITs are companies that develop, own and operate commercial properties, such as office buildings, retail centers, medical facilities and industrial warehouses. Supported by the rental income of their underlying properties, REITs typically bene?t from relatively stable cash ?ows and offer compelling current dividends as they are required to pay out 90% of the income they derive from investments. Equity REITs, which form the largest group of REITs and tend to have a lower risk profile than other REITs categories, invest in commercial real estate assets. Investors need to consider the special risks associated with an investment in real estate including credit risk, interest rate fluctuations and the impact of varied economic conditions. For more information on the income opportunities and risks associated with REIT Preferreds, a sub-segment of the REITs market, download “REIT Preferred Stock – An Introduction” published by Elder and Baird Real Estate Research Analyst Chris Lucas.

Master Limited Partnerships (MLPs)Master Limited Partnerships (MLPs) are publicly traded partnerships that combine tax benefits of a partnership with the liquidity of a publicly traded company. MLPs often operate in energy or natural resource related businesses and generate income from extraction, transportation, storage or wholesale distribution of fossil fuels. They are of interest to income-oriented investors because they typically operate in steady businesses with strong cash flows. Yields typically range from 4% to 9% depending on risk and growth.

While MLPs have the potential to offer a compelling total return proposition for investors, they are more complex vehicles with unique risks. According to Baird Energy Analyst Ethan Bellamy, “MLPs are equities with commodity price exposure. While many of the businesses of MLPs are defensive, owning an MLP does not insulate investors from capital losses.”

Unconstrained Bond FundsUnconstrained bonds funds are a relatively new group of bond funds that have emerged recently, allowing portfolio managers to fully position and tactically shift their portfolios to take advantage of opportunities and hedge against risks that traditional bond fund mandates may not allow.1 Unconstrained bond funds can allocate assets across various sectors, credit qualities, geographies, interest rates and currencies with the flexibility to adjust allocations as opportunities or risks arise.

“With unconstrained bond strategies, investors are giving full reign to the portfolio managers with an expectation of strong risk-adjusted returns over time,” Thurow said. “The investor must have full conviction in the portfolio management team to be able to navigate through different market environments. Most unconstrained bond strategies have limited track records in the mutual fund space, which adds an element of risk to the portfolios.” For more information, download a recently published report, “Mutual Fund Ideas – Unconstrained Bond Funds,” that outlines the risks and potential rewards of these funds.

To arrange an interview with Craig Elder or Laura Thurow to discuss options for investors seeking yield, contact Amy Nutter at (414) 765-7250 or publicrelations@rwbaird.com.

About BairdBaird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,600 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of nearly $84 billion. Committed to being a great place to work, Baird ranked number 14 on FORTUNE’s “100 Best Companies to Work For” in 2011 – its eighth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at rwbaird.com.

1 Funds invested in foreign debt obligations or securities carry risks such as currency rate fluctuations, different and sometimes less strict financial reporting standards and regulation, and the potential for political and economic instability. Due to the effect of compounding, operating expenses and daily resets, the performance of leveraged and inverse funds over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. Leveraged and inverse funds are complicated instruments that should only be used by sophisticated investors who fully understand their complexities, terms, structures, tax implications and risks.

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